MyCIMA

SOS, Financing Costs

Posted: Saturday 20 November 2010 by Matt12345
Replies : 1
Keywords: P09 Financial Strategy

Hi,

This is a bit of a long one, though I hope the answer is short and that someone will be kind enough to help.

 I have been getting a bit confused when dealing with debt interest in investment appraisal and calculating a weighted average cost of capital.

 My issue is as follows:

 WACC = Finance and bus. risk same as project being evaluated

WACC (adjusted) = CAPM Beta factors if only business/ project risk changes

ADR/APV = Treat business risk as 100% equity finance and calc PV of financing separately. ADR calculated based on opp cost of APV at Ke.

 Ok this I thought was fairly straight forward, what is confusing me is that I have seen a few variations in question where these rules get muddles and it is confusing the heck out of me. In particular.

Where debt is used to fund a project and asked to calc a new weighted average cost of capital, assume this is ok as debt is used to fund an expansion and would effect whole company the same.

A project in a new industry, Beta factors given in question. Told the project would be funded by2*15% debentures. Solution was an NPV of project cash flows, with DCF (discount rate) calculated using CAPM. What is confusing me here is the debt changes the gearing, so how can the Capm model be used and why is tax relief on debt interest payments ignored????

A question evaluating a lease buy decision for an asset. (Nov 08 Exam, BG). The buy option is evaluated as if 100% equity financé with just tax relief on the capital allowance. The tax relief on the debt 9.2% is ignored. The rate used is post tax marker return on debt (opp cost as lease is alt to debt). Again debt change gearing, but evaluated on opp cost not WACC. Side steps issue, but does not explain ignoring tax relief on debt intrest????

 

Can anyone clarify what is the missing piece that makes this clear???

At present I can use the following rule of thumb, but lack understanding:

* If given a Beta fact use Capm and treat as all equity financed, ignore relief on debt.

* If evaluating two projects and not asked specifically to calc APV, treat as all equity finance and ignore tax relief on debt interest payments.

In summary

 Confused regarding tax relief on debt interest and why when debt is used CAPM and WACC is used when this will effect gearing.

 Please advise

 Matt

 

Lease or Buy

Posted by Jimmy P on Sunday 21 November 2010 16:41

Matt,

 Not sure about the first problem as I am not sure about the detail of the questions. You can use a beta to calculate Ke or Kd, or ungeared Ke using an asset beta. If the project is significant, then you could argue that the project specific cost of capital is the cost of debt that is taken to fund the project. If you give more specifica I may be able to help further.

 With the lease or buy, the discount rate used is the cost of debt after tax. Don't know why is would be done with cost of equity. The interest payments and their tax benefits are no included as the present value of any loan is the initial principle. This discount rate is used for both lease and the but decision.

 Remember to include the tax benefit of the lease payments though.

 Hope this helps. 

 Jimmy